New Part of Credit Market Hit by Home-Loan Jitters

By GRETCHEN MORGENSON and JENNY ANDERSON

Published: August 15, 2007

CORRECTION APPENDED

Turmoil in the subprime mortgage market spread again yesterday -- this time to a type of short-term security held by money market mutual funds. These funds have become the investment of choice for many people seeking a safe haven.

Standard & Poor's, the ratings agency, warned yesterday that it might downgrade several issuers of commercial paper, a short-term I.O.U. by companies that promise to repay loans typically within a few weeks to a year.

In these cases, S.& P. said, the commercial paper was backed by residential mortgages.

The amount of commercial paper in the United States has grown to $2.2 trillion, according to Lehman Brothers, with about $1.2 trillion backed by residential mortgages, credit card receivables, car loans and other bonds. The major buyers include pension funds, insurance companies, hedge funds and short-term money market funds.

Investors have flocked to money market funds as they try to avoid volatile stocks and the seized-up bond market. Last week, more than $36 billion moved into money market funds, the largest shift since December 2005. In all, some $2.6 trillion is in money market funds, according to AMG Data Services.

Such funds are sold to investors as the equivalent of cash, and their $1-a-share net asset value is considered inviolate. But if the funds experienced big losses, the value of the assets could be vulnerable.

The S.& P acted a day after a $1.6 billion cash-management fund run by the Sentinel Management Group halted redemptions because it could not sell its assets at what it considered acceptable prices.

Until recently, the crisis in the credit markets has been limited to problems related to subprime mortgages, those given to borrowers with questionable credit histories. But as these troubles seep into other parts of the securities markets, fears of losses are rising in unexpected places.

The borrowers, companies that issue asset-backed commercial paper, have found it highly profitable. These companies usually have used the money they borrow to buy securities like slices of mortgage pools that generated yields much greater than the interest paid to the short-term lenders.

But there are several risks. First, the companies that issue short-term notes backed by assets with considerably longer terms are exposing themselves to the risk that the interest they earn will not exceed the amount they must pay to their lenders. Perhaps more significant, the borrowers must be concerned about possible losses in the assets they buy, especially when investors will no longer lend them money by buying their commercial paper.

The S.& P. highlighted four issuers of commercial paper for possible downgrading. Broadhollow Funding, which was set up by American Home Mortgage Investment, a lender that filed for bankruptcy last week; KKR Atlantic Funding Trust and KKR Pacific Funding Trust, two affiliates of the buyout firm Kohlberg Kravis Roberts; and Ottimo Funding, an affiliate of Aladdin Capital Management, an investment manager in Stamford, Conn.

Kohlberg Kravis declined to comment yesterday.

Ottimo Funding holds about $3 billion in residential mortgages, all rated AAA. George Marshman, chief investment officer at Aladdin, said: ''It's a negotiation process. We're working with all the investors to make things as orderly as possible. I'm optimistic we can get a good outcome.''

Among the money market funds that held commercial paper issued by the companies singled out for possible downgrading were two offered by Evergreen Investments. As of May, the $16.6 billion Evergreen Institutional Money Market Fund held $385 million in Broadhollow Funding and $72 million in Ottimo Funding. The $4.5 billion Evergreen Prime Cash Management Money Market Fund held $50 million in Ottimo Funding as well.

Mary K. Athridge, a Legg Mason spokeswoman, said in a statement: ''The holdings represent less than 1.4 percent of the portfolio. We believe the current disruption in the marketplace is liquidity-related rather than credit-related, which the Fed has stepped into the market to address.''

As of May 31, Columbia Funds Series Trust Cash Reserves, a $62 billion fund, had a $120 million stake in Ottimo Funding and $400 million in KKR Pacific Funding Trust. A Columbia Management spokesman did not return calls for comment.

''If the stigma of mortgage-related extendable-asset-backed commercial paper spreads to asset-backed commercial paper as a whole, you could see bailout events,'' said Peter G. Crane, president of Crane Data, the publisher of a newsletter about money market mutual funds. But he added: ''The stuff that the money funds are invested in are the highest quality, so it's the last thing to have trouble.''

However, the investment strategies that once were considered conservative no longer are.

The Sentinel fund that banned redemptions Monday advertised itself as risk-averse. In a letter to investors, Sentinel said that it had hoped to ride out the troubles but was unable to do so.

''We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients,'' the letter said. ''We will continue to monitor the markets and we will raise cash as opportunities present themselves.''

Sentinel officials did not return calls for comment.

Douglas A. Kass, general partner of Seabreeze Partners Management, an investment firm in Palm Beach, Fla., said the Sentinel disclosure and upheaval in commercial paper markets are examples of the risks investors take when they reach for higher yields.

''This is symptomatic of a whole body of investors, including money market and cash management funds, that are attempting to enhance yields, and this is the downside to that journey,'' he said.

On Monday, Coventree, a Canadian financial services company, said it could no longer issue asset-backed commercial paper because of a liquidity squeeze. In a statement, the firm said that ''problems that initially seemed isolated to a few U.S. subprime mortgage lenders have led to broader concerns relating to debt capital markets generally,'' including the market for Canadian asset-backed commercial paper.

Coventree extended maturities on 250 million Canadian dollars ($237 million) and sought emergency funding for an additional 700 million Canadian dollars ($664 million).

In its third-quarter financial statement yesterday, Coventree said: ''Certain liquidity providers have advanced funding, some have disagreed that they have an obligation to fund, some are in discussions with the company, and some have not responded. There is no assurance that the liquidity providers will fund or be obligated to fund under the requisite liquidity agreements.''

Canadian companies have issued 170 billion Canadian dollars ($161 billion) in commercial paper, according to a Lehman Brothers research report citing Bank of Canada data. About 116 billion Canadian dollars ($110 billion) of that market is asset-backed commercial paper, up from 66 billion Canadian dollars ($63 billion) at the beginning of 2005.

Correction: August 16, 2007, Thursday
An article in Business Day yesterday about jitters in the market for commercial paper backed by residential mortgages misstated the number of issuers in that market who were warned of possible downgrades on Tuesday by Standard & Poor's, a ratings agency. It warned three commercial paper issuers, not four. (It put a fourth issuer, Broadhollow Funding, on watch on Aug. 6.)